The new 2001 Tax Relief Reconciliation Act has 85 new provisions, 441 codes changes and 291 pages of text.  We will probably spend the next several months reviewing and presenting its many new provisions in more detail, but we can already summarize the major aspects of the bill here so that you can begin some early planning.  The gradual phase-in of the new tax rates and provisions will pretty much dominate our tax planning for many years to come.

Declining Tax Rates

Obviously, the single most important factor with most of our clients is the lowering of tax rates.  There is a new 10 percent rate bracket that will result in "advance refund" checks being issued to most taxpayers by October 1, 2001.  Since the first $6,000 of your income ($12,000 joint and $10,000 head of household) is now taxed at only 10%, the IRS will be issuing "refund" checks of $300 ($600 joint and $500 head of household) to every taxpayer for 2001.

As you can see from this table, the actual decrease in the rates is minimal for the next year or so and the old 15% tax bracket has been divided into two tax brackets - 10% and 15%.  A comparison of the tax rate tables (joint return only) for last year (2000) and 2006 when the rates are fully phased in looks like this:

To put the effect of the new tax rates in a format a little easier to understand than the above table, lets assume an example of a married couple filing a joint return using the above rates at different income levels.  The resulting savings would be as follows:

One might think from the percentage reductions above that lower-income taxpayers fared considerably better under the new tax cut legislation than did their higher-income brethren.  However, the example above looks only at the tax rates applied to taxable income.  Higher-bracket taxpayers also received a break in arriving at their new taxable income through the gradual elimination of the current limitations on itemized deductions and personal exemptions.

The itemized deduction limitation and personal exemption phase-out will be reduced by 1/3rd in 2006 and 2007, 2/3rd in 2008 and 2009, and will be totally eliminated in 2010.  

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The Alternative Minimum Tax Rears Its Ugly Head

Unfortunately for the innocent CPA, many of our clients who are already subject to the alternative minimum tax (AMT) are going to be disgusted to learn that they may receive no tax break whatsoever.  Furthermore, by the time all of the benefits under the Relief Act are fully phased in, its being projected that the number of taxpayers subject to the AMT will increase six-fold over the present number.

The AMT rates and income levels subject to those rates were not changed under the new law.  Congress did address some of the AMT issues, but they quickly realized that any wholesale changes to the AMT rates would drive the cost of their legislation up considerably.  Unless future legislation changes this situation, we fully expect to be explaining the AMT rules to more and more surprised clients over the next few years.

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Possible Tax Strategies With The New Relief Act

Shifting your income within the family

We have always advised clients to shift income to their children whenever the opportunity arises so long as the child isn't subject to the "kiddie tax" (under 14 years of age).  With the new 10 percent rate on the first $6,000 of income, it makes even more sense to redirect interest and dividends to a child or other family member in the lower tax bracket.

Business entity

With personal tax rates now falling substantially below the average corporate tax rate, more business owners may want to consider operating their company as an S corporation, sole proprietorship or partnership rather than a C corporation.  Having your business earnings taxed at the individual level instead of the corporate level can potentially save you thousands of dollars each year.

Deferring income

Any time you have an environment of gradually falling tax rates, it makes sense to defer income whenever possible.  Deferred compensation agreements and the timing of bonuses will take on added significance for the next several years.

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Other Important Provisions In The Act

Child Care

The new law provided tax relief across several fronts to families with children:

• Child Tax Credit - The current child tax credit of $500 per child will immediately increase to $600 for 2001 through 2004.  The credit increases to $700 from 2005 to 2008, $800 in 2009 and $1,000 in 2010.  The existing gross income levels for the child tax credit ($110,000 joint and $55,000 single) remain unchanged.  

• Adoption Credit - Beginning in 2002, the credit for adoptions will increase to $10,000 for both special needs and non-special needs adoptions and the starting point of the income phase-out range will increase from $75,000 to $150,000.

• Dependent Care Credit - Beginning in 2003, the dependent care credit rate goes from 30 to 35 percent and the amount of eligible employment-related expenses will rise from $2,400 ($4,800 for multiple children) to $3,000 ($6,000 for multiple children).  The beginning point of the income phase-out amount will increase to $15,000 of adjusted gross income.

• Credit for Employer-Provided Child Care Facilities - Starting in 2002, employers will be allowed to claim a credit equal to 25% of qualified expenses for employee child care and 10% of qualified expenses for child care resource and referral services.  The credit will be capped at a maximum of $150,000 per year.

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Education Tax Cuts

Families with children not only are receiving tremendous tax breaks through the various credits, but the Relief Act has greatly expanded the scope of the education benefits initiated over the past few years:

• Education IRA - This program has been expanded tremendously under the new law.  Education IRAs will now cover not only the costs of higher education, but also the costs of public and private elementary and secondary education.  Beginning in 2002, the annual contribution limit to education IRAs will rise from $500 to $2,000 and contributions will be allowable from corporations, tax-exempt organizations and other entities (presently, only individuals can make contributions).  Contributions will also be permitted all the way until the filing date of the return (April 15th of the following year) and the adjusted gross income ceiling for allowable contributions has been raised from the present $150,000 to $160,000 phase-out range to $190,000 to $220,000.

• Tuition Deduction - Beginning in 2002, you will be entitled to a deduction for qualified tuition costs of $3,000 provided your adjusted gross income is below $65,000 ($130,000 joint).  In 2004 and 2005, the deduction will increase to $4,000.  Also, in those years, you will be allowed a $2,000 deduction if your income is between $65,000 and $80,000 ($130,000 and $160,000 joint).  The college tuition deduction ends after 2005 and cannot be claimed in the same year as a HOPE or Lifetime Learning credit for the same student..

• Student Loan Interest - The new law eliminates the $2,500 limit on deductible student loan interest and raises the income phase-out thresholds to $55-65,000 single and $100-130,000 joint.  The old rule that only interest attributable to the first 60 months in which interest payments are required has been repealed along with the restriction that voluntary payments of interest are not deductible.

• Qualified Tuition Plans - Private institutions of post-secondary learning will now be able to sponsor qualified tuition programs whereby taxpayers may pre-pay tuition costs.  Under prior law, qualified tuition plans had to be state-sponsored and could cover only higher education costs.  Distributions from qualified tuition programs will be excludable from gross income if made after December 31, 2001 from state-sponsored plans or December 31, 2003 from non-state programs.

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The Marriage Penalty

Congress finally addressed the age-old marriage penalty inherent in the Tax Code, but unfortunately, you will have to wait until 2005 to begin seeing any benefits.  Beginning in 2005, joint filers will see their standard deduction increase to 174% of that for singles.  It will continue to increase in the following years (184% in 2006, 187% in 2007 and 190% in 2008) until it reaches the full 200% in 2009

Also, beginning in 2005, the high-end of the income level falling under the 15 percent tax bracket for joint filers will expand to 180% of the income level for single filers.  This income level will continue to rise in the following years (187% in 2006 and 193% in 2007) until it reaches the full 200% in 2008.

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Estate Taxes

The estate tax has been repealed!  Um...well, for one year only - 2010.  In an odd compromise, Congress repealed the estate tax for 2010, but allowed the current estate tax rules, rates and exemptions to come back in 2011.  We're not exactly certain what to make of this except that it is an issue which will obviously be addressed again at some point in the future.  Whether the "repeal" will actually remain in place for 2010 is open to some doubt.

The estate tax exemption amount, however will gradually increase to $3.5 million in 2009 while the top tax rate falls to 45%.  Also, the credit for state death taxes paid will be phased out beginning in 2002 and replaced by a deduction for state taxes paid.  A schedule of the changes is as follows:

Even if the potential repeal of the estate tax in 2010 holds out, that will not mean that your family's holdings will forever escape the long arm of Uncle Sam.  The basis of the assets received from a decedent will carry over from the decedent instead of receiving the step up in basis to fair market value under current law.

Basically, this means that if you purchased $10,000 of Microsoft stock in 1982 and your children sell it for $40 million after your death, they will be taxed on a capital gain of $39,990,000.  Under current law, the Microsoft stock would be taxed as part of your estate at the time of your death and your children would receive the stock with a basis of its fair market value at that point.

The new law will, however allow $1.3 million of basis to be added to certain assets in your estate and $3 million of basis can be added to certain assets transferred to a surviving spouse.  Also, starting in 2010, gifts in excess of a lifetime $1 million exemption will be subject to a gift tax equal to the top individual tax rate at the time.

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Retirement Savings

The new law has greatly expanded almost every retirement savings program available under the Tax Code:

• IRA contributions - The IRA contribution limits (both traditional and IRA) will rise to $3,000 in 2002, $4,000 in 2005 and $5,000 in 2008.  After 2008, annual adjustments may be made for inflation.   If you are age 50 or over, you will be permitted to make "catchup contributions" to your IRA of an additional $500 beginning in 2002 and rising to $1,000 in 2006 and thereafter.

• 401(k) contributions - Salary reduction contributions to 401(k), 403(b) and SEP plans are scheduled to rise to $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and $15,000 in 2006.

• Defined contribution and benefit plans - The limit on annual additions to a defined contribution plan will rise to $40,000 in 2002 and the annual limit on benefits under a defined benefit plan will rise to $160,000, also in 2002.  Also, the new law increases the protection of plan participants, including shortening vesting schedules and enhancing portability of pension assets.  Employees are now required to become vested in eligible for matching employer contributions in a maximum of 3 years instead of 5.  The limit on compensation taken into account under a qualified plan is now $200,000 and will be increased in $5,000 increments for inflation.

• Contribution tax credit - Contributions to retirement savings will qualify for a tax credit instead of just a tax deduction for lower income taxpayers.  Joint filers earning less than $30,000 will be entitled to the maximum 50% credit.

• SIMPLE plans - The limit on maximum annual elective deferrals will increase to $7,000 in 2002, $8,000 in 2003, $9,000 in 2004 and $10,000 in 2005.

In addition to the above changes, the Relief Act also modernizes and streamlines the pension laws to encourage small businesses to off plans.  The "top-heavy" rules have been modified, the limit on employer deductions for contributions to defined contribution plans has been raised to 25% of compensation, and there is now a tax credit for small business retirement plan start-up costs.

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SUMMARY

This analysis only touches on the key highlights of some very major tax reforms.  You can rest assured that we will be reviewing each of these sections of the Relief Act in more depth in upcoming articles.  Until then, if you have any questions over how certain new provisions of the Act may affect you personally, please do not hesitate to contact our office.

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